How You Can Profit From the Coming Merger Mania

With interest rates so low and corporations sitting on $2 trillion in cash, a slew of mergers and takeovers across a number of industries appears likely in 2011. That should give investors plenty of opportunity to capitalize on large corporations' willingness to pay premium prices to acquire competitors or strategic partners. Priivate equity firms and hedge funds will also be very active acquirers.

Most target companies' stock prices rise after a merger is announced, especially if a bidding war develops among several competing acquirers. So, investors who want to capitalize on M&A should begin developing a strategy now. But how?

One way to take advantage of next year's M&A revival would be for investors to identify takeover targets themselves, but that's extremely difficult. More feasible would be to scout out mutual funds or exchange traded funds (ETFs) that aim to profit from the M&A boom.

The Only M&A ETF

Experts say a strategy know as "merger arbitrage" can diversify an investment portfolio because it's generally less volatile than pure equity investments in potential merger companies, and it works in all market conditions. Mutual funds that pursue merger-arbitrage strategies include the Merger Fund (MERFX), the Arbitrage Fund (ARBFX) and the AQR Diversified Arbitrage Fund (ADAIX).

The IQ Merger Arbitrage ETF (MNA), which is a little more than a year old, is currently the only ETF that attempts to replicate the market for global mergers. Adam Patti, CEO of IndexIQ which manages the ETF, says his firm focuses on merger targets after they've been announced, then it uses special criteria to determine how they're likely to perform post-merger. Each month, IQ Merger Arbitrage evaluates the field and buys the best prospects to hold in its portfolio.

"The typical successful deal moves 3% to 4% higher over an average 120-day holding period," Patti says. Many mergers send the target company's shares even higher.

Banking and Health Care Should Be Hot

Several sectors have already been identified as ripe for M&A next year. Financial services is likely to see more deals in 2011, and financial services research firm Keefe, Bruyette & Woods (KBW) has even listed banks it believes will be takeover targets next year.

Raymond James banking analyst Anthony Polini recently told The Wall Street Journal that he expects hundreds of banking sector takeovers within the next five years, mostly due to tougher economic conditions and more stringent financial regulations. "A lot will be below the radar, but I think we could go from 8,000 banks to 6,000," he said.

The health care industry is also ripe for more takeovers. Tim Nelson, an analyst at FAF Advisors, told Reuters recently that companies like Medtronic (MDT), Johnson & Johnson (JNJ), Abbott Laboratories (ABT) and Pfizer (PFE) will likely turn to acquisitions to improve their lagging performance over the past several years.

"[The] big guys are looking anywhere they can to get reasonable growth that can move their needle. That's not easy," said Nelson. "I think you'll see them buying more earlier-stage technology [companies]."

"A Great Spot to Be In"

Patti is forecasting a big year for mergers in the natural resources and small-cap technology. In the natural resources area, mining companies will be particularly attractive due to the scarcity of many mined commodities and the increasing demand from emerging-market countries like China and India.

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"Whether they are mining gold or other materials, exploring for oil reserves or even agri-business-type companies -- that's really a great spot to be in," Patti says.

He also sees small tech companies as prime merger targets because they're more likely to see lucrative buyouts as an alternative to risky and expensive IPOs. Patti also notes that these companies will become attractive to cash-laden tech giants because "sometimes it's easier and cheaper to buy [technology and market share] than build."

The IQ Merger Arbitrage ETF currently owns shares of DelMonte (DLM), Genzyme (GENZ), J. Crew Group (JCG), AirTran (AAI), McAfee (MFE) and CommScope (CTV). As of Dec. 22, its total return is down 1.37% year-to-date, according to data from Morningstar. As of Dec. 22, total returns year-to-date for the Merger Fund are up 2.96%, the Arbitrage Fund is up 1.58% and the AQR Diversified Arbitrage Fund is up 4.44%.